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Investing in a polarised world

Russell Napier, financial historian and Keeper of the Library of Mistakes, explains why investors should brace for long-term inflation
May 31, 2022

Professor Russell Napier set up Edinburgh’s ‘Library of Mistakes’ in 2014 to counter historian James Grant’s famous quote “Progress is cumulative in science and engineering, but cyclical in finance”. Aware of the scale of the challenge, Napier knows he won’t succeed in changing that, but says he will be content if the institution can make the accumulation of knowledge even “slightly better”.  

This might resonate with those who have lived through periods of high inflation and question the laissez faire attitudes of those who haven’t. Napier, who advises on asset allocation for institutional investors, believes that we have a long period of elevated inflation ahead of us, and that this is effectively controlled by government policy.

When the pandemic struck in 2020, the UK government partially guaranteed commercial loans made by the banking system, knowing that some of them wouldn’t be repaid and some of them would be maintained fraudulently. “I’m having a real problem convincing the marketplace of this but in my opinion that means the government now runs monetary policy, not the central banks,” Napier says. 

The expectation was that as soon as the pandemic ended the government would stop such practices, but when Boris Johnson guaranteed the credit on bank loans made to Jaguar Land Rover a couple of months ago this raised Napier’s suspicions, and he adds that Emmanual Macron in France has indicated that he will be doing the same thing. 

“The transformation here is that the government through sticks and carrots is controlling the balance sheets of the central banks,” he says. “According to the Bank of England definition of how money is made, that means governments are now in the business of making money. And if that's true, prepare for inflation, because governments will make too much money [as] they are using it to finance all their pet projects.”

This is why Napier thinks inflation is much more systemic than current narratives imply. There are many projects for which governments urgently need money - not least diversifying energy from Russia, rolling out a climate emergency investment project and perhaps even diversifying away from the risks presented by China. “The governments effectively control the commercial banks, they will use them to fund all of this investment, and in doing so, create a lot of money and create a lot of a lot of inflation,” he says. 

This is why Napier is not that focused on central bank policy or interest rates. “Monetary policy is not the price of money," he says. "Ultimately, it's the quantity of money. You should think of the price of money as the brake or the accelerator in a car, but it's not the engine, the engine is the commercial banking system.”  

For this reason, he thinks that rather than dwell too heavily on central bank interest rate decisions, investors need to look at bank lending for evidence of money supply growth, and then look at whether governments are extending credit guarantees. In this context, "the speeches by [Emmanuel] Macron on 17 March and [Jean] Castex on 16 March were crucially important and yet [largely] unreported,” he says. “Basically France has a new industrial policy, and no one seems to care.” Napier adds that he thinks the speeches made it “pretty clear” that industrial growth will be financed by the banking system, using sticks and carrots - effectively a return to European policies of old.

The world has seen a huge injection of capital since early 2020, most notably in the US where broad money supply grew by 40 per cent. While bank credit growth is now starting to come down, Napier says that there is usually an 18-month lag in the relationship between the supply of money and inflation.  

“You wouldn't really expect all this money creation to have an impact on consumer price inflation [yet]," he says. "It might have an impact on asset price inflation, but not consumer price inflation for 18 months. There’s certainly plenty of inflation in the tank.” 

More encouragingly, Napier is not that concerned about equity markets' recent struggles. “The belief that a ratcheting up of interest rates is going to destroy nominal GDP growth is, I think, unrealistic,” he says, questioning whether central bankers, when push comes to shove, will have the stomach for such moves.

Napier cites five ways governments can bring down inflation, ranging from very high levels of growth, to austerity, default, hyperinflation or financial repression. Of these, he thinks the last is the only option that is both feasible politically and achievable.

Financial repression (which Napier calls ‘stealing money from old people slowly’) is the practice of keeping borrowing rates below the inflation rate in order to gradually inflate away debt. Napier says this is effectively only achieved by regulation.  

“Depending on where you sit in the spectrum of savings institutions, many of them are already being forced to [buy low-yielding assets] by the government through asset liability modelling,” he says. “And we can ratchet that up.” This is how the government reduced its debt after world war two. If you add household and non financial sector corporate debt to government debt, the UK’s debt to gross domestic product is currently higher than it was after that conflict, Napier says. 

 

Relations with China

Buying cheap goods from China has been a significant deflationary force in the West in recent decades. But Napier thinks that a decoupling is taking place. “I’ve been talking about this for a while but Janet Yellen summed it up in a fantastic soundbite on 14 April: 'friend-shoring'."

Friend-shoring is the practice of only buying products from countries with whom you are on friendly terms - as well as building capacity to produce these products only in such countries. In terms of those who are excluded, Yellen unsurprisingly highlighted Russia, but also alluded to China - which, she said, "needs to take seriously [the practice of] working with us."

In China's absence, Napier says, friend-shoring means "a massive redirection in the flow of goods, but prior to that a massive redirection in the flow of capital, which we are already seeing, with investors pulling $17.5bn (£13.84bn) from renminbi-denominated portfolio assets in March alone”. 

Napier says that he has never invested in China and advises investors against doing so. “In discussions with my institutional clients, I think the terminal value of their Chinese investments is zero. Not because the share prices go to zero - there's another way you can lose all your money, which is they don't let you sell the currency”.

Many people will remember a bipolar world - the Cold War - when capital did not flow freely between the Soviet Union and the west. Napier thinks that this is the direction of travel with China. “We all hope that we don't head to a bipolar world because if it's a Cold War, there were hot flashes in the last one and hundreds of thousands of people died. So we're all hoping that we can avoid the bipolar world, but it's looking very likely at the minute and to me, that means China's on investable.”

 

Where to invest

Napier believes that much of the global stock market is overvalued and the sell off among growth companies in recent months has further to run. He says investors should instead be looking at the industries that have been destroyed by China over the past 30 years because the west has moved production there. China was able to outcompete most businesses, not least because it used an undervalued exchange rate with capital cheaply priced by the state. 

“The fact that our steel companies have survived at all is pretty remarkable,” he says. “And they may have only survived with a little bit of government support themselves but I think it means that they're quite good companies.”

In contrast to the UK, he notes that there are several such businesses left across Japan, South Korea, Germany, France and the US. 

Napier says that these companies become essential when Chinese competition disappears. His objection to sustainable investing arguments is that steel produced in Europe, Japan and America is much greener than that produced in China, and the technology is coming on in leaps and bounds - the use of hydrogen being one major recent breakthrough.  

The problem for investors is that these companies now make up such a small percentage of market capitalization that most fund managers would not have courage to significantly over-commit to that portion of the market, according to Napier. “Who wants to own chemical manufacturers, steel manufacturers and shipyards?” he adds.

Napier is not a fan of index funds - particularly in the US - because he believes that they are full of yesterday’s winners and not suitable for current conditions. While it’s not easy to find an active manager with the courage, ability and skill set to pick stocks well, Napier suggests looking at ‘value’ funds with a heavy industry bias and doing as much research as possible on the fund's manager. He cautions against the broad US market because the Q ratio (the price of stocks relative to the replacement cost of assets) is at an all time high - above levels reached in 2000 and 1929. “If we're talking about mean reversion and aggregate for equities, you can imagine that that does not augur good returns for US equities,” he says. 

In terms of his own asset allocation, Napier says he’s been buying more value funds and that he has a geographical bias towards Japan, which he views as a major beneficiary of rising inflation and ongoing tensions with China.  

 

Listen to the full interview

Russell Napier CV

Honorary Professor: Heriot-Watt University and The University of Stirling. Course: Advanced Valuation in Financial Markets.

Co-founder: online research portal ERIC. Writes "The Solid Ground," a global macro investment report for institutions.  

Author: Anatomy of the Bear: Lessons from Wall St’s Four Great Bottoms and The Asian Financial Crisis 1995-98: Birth of the Age of Debt.

Chairman: Mid Wynd International Investment Trust

Keeper: The Library of Mistakes (founded in 2014)

1995 - 2014, CLSA (equity strategist)

1994 - 1995, F&C Emerging Markets

1989 - 1994, Baillie Gifford